Spinoffs, Kickbacks and Arbitrage

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Do you think that Hillary Clinton and Donald Trump know that hedge fund managers don't benefit much from the carried interest tax break? (Because hedge funds mostly produce short-term capital gains, and the tax break really benefits people, like venture capitalists and private equity and real estate investors, who receive carried interest for managing long-term investments.) Probably, right? So why do politicians talk about carried interest as a hedge fund issue? Probably because "hedge fund fat cats" is more fun to say than "venture capital fat cats." The "hedge fund" branding has really backfired. Everyone expects you to hedge, your performance is aggregated with that of day-trading soi-disant "hedge fund managers" to prove that your industry is a rip-off, and you get criticized for a tax break that doesn't even apply to you. If I ran a hedge fund I'd tell people I was an alternative asset manager.

Elsewhere in taxes, yesterday we talked about the Yahoo spinoff saga, in which Yahoo is proceeding with its spinoff of its Alibaba shares despite the IRS's refusal to bless it. But I may have been too negative in suggesting that the IRS's "sullen grievance is of course a well-known precursor to litigation." One thing that is fairly clear is that the IRS doesn't like what you could call "hot-dog-stand spinoffs," where a company spins off an appreciated asset (here, Yahoo's Alibaba stock) by combining it with a minimal active trade or business (a "hot dog stand," in one IRS official's words, or, here, Yahoo Small Business). So the IRS wants to change the rules to prevent those hot-dog-stand deals. One way to do that is to change the rules; the IRS seems to be considering that. Another way to do that is to conclude that the rules always prevented these deals, and to sue someone (Yahoo) for doing one. That, let's be clear, is how a lot of U.S. financial law enforcement operates; as I've said in this context, "the rules are often decided in hindsight, one controversy at a time, by punishing the last guy who did something controversial rather than by announcing that the next guy to do it will be punished." If something done under the current rules seems outrageous, it is not hard to convince a jury that it actually violates the rules.

But this is a less popular approach in tax law, which tends to be practiced as a values-free field of pure aesthetic and intellectual endeavor, and to take precedent and formalities seriously. It might be hard for the IRS to stop the Yahoo deal by claiming that it is illegal under current law, given the weight of IRS precedent suggesting that it is perfectly legal. And if the IRS did sue, and lost, then it would be harder for it to make new rules to stop future hot-dog-stand spinoffs, since a court opinion against it might constrain its rulemaking discretion. So there are some good reasons to think that, even if the IRS dislikes the Yahoo spinoff, it might not litigate it, which I'd have to assume is why Yahoo's lawyers told it to go ahead.

Investment advisers.

Here is an op-ed by Lily Batchelder and Jared Bernstein arguing in favor of the Department of Labor's proposed "conflict of interest" rules that would make it (somewhat) harder for retirement-product brokers to get paid by mutual fund companies for recommending their funds without transparently disclosing those payments to customers. This seems a little extreme:

Critics of the proposal argue that it would hurt the retirement security of low- and middle-income Americans by reducing access to financial advice, as if more advice equals good advice. By that logic, sending Bernard L. Madoff to jail was bad for middle-class savers because they had fewer advisers to pick among.

Ehh. I think the model is: You can (A) get financial advice that is paid for through nontransparent kickbacks that are paid out of overpriced mutual fund fees, or (B) get financial advice that is transparently paid for by you. When I put it like that, you, the sophisticated reader, would probably choose option B. (Or you'd self-advise and buy index funds, like I do, though I certainly do not recommend that you take financial advice from me.) But it does seem possible that transparent fees would turn some people off to retirement advice -- and, perhaps, to retirement saving -- entirely, since people are more likely to consume free ("free") products than expensive ones. It's also possible that saving an adequate amount in an overpriced underperforming mutual fund is a better outcome than saving an inadequate amount, or nothing, in a low-priced index fund. Both of these are distinctly sub-optimal, of course, and I tend to sympathize with the idea that retirement brokers should be fiduciaries, but I don't think it's quite as easy as Batchelder and Bernstein make it out to be.

Elsewhere: "The Biggest Reason Workers Don't Save for Retirement" is that their employers don't offer 401(k)s. A survey of millennials found that more than 10 percent would choose Jessica Alba over Warren Buffett to be their financial adviser, though I don't know what kind of fees Alba or Buffett would charge. A Merrill Lynch private banking team in Newport Beach with about $3.3 billion of client assets left last week to start their own boutique. And the Securities and Exchange Commission "announced fraud charges against a registered investment adviser and its owner for allegedly engaging in self-dealing and failing to disclose material facts to clients regarding conflicts of interest, use of investor funds, and the risks of the investments they recommended."

ETF arbitrage.

Here's an interesting story about hedge funds who are "concocting ways to capitalize on potential weak spots in exchange-traded funds." Some of the exact strategies are unclear, but many of them seem to involve arbitraging disconnects between the ETF and the underlying thing that it represents. It's worth saying that that's the point of ETFs: They're supposed to track the underlying thing, and they do that by creating an arbitrage mechanism in which third-party traders keep the price honest by buying the thing and selling the ETF if the ETF gets overvalued, or selling the thing and buying the ETF if it gets undervalued. So if a hedge fund spots a flaw that leads to the ETF being disconnected from its underlying, and takes advantage of it, then that will tend to push the prices back into line, and be a good thing for the ETF. Generically. Of course if the arbitrage persists, the hedge fund will make money on it at the expense of the ETF investors. One example in the article is a futures roll trade, and people often dislike it when hedge funds exploit anticipated futures rolls, though really it's just propagating price efficiency through time.

This, though, sounds like a perpetual motion machine:

Hedge-fund traders believe that over the long term, relatively high fees and a complicated system of rebalancing holdings daily reduce the potential upside of leveraged ETFs in market upswings and exaggerate their falls in a pullback.

Their trade: short both bearish and bullish leveraged ETFs in the same industry. If the market goes up, the bearish ETFs will fall more than the bullish ones gain, allowing the trader to make more on his short of the bearish fund than he lost on the short of the bullish one. The trade also pays if the market goes down.

I assume the explanation is that this is a long-gamma trade and loses money if the market is flattish, but still, if it works it does seem a little too easy.

Corporate governance.

Here are two essays on corporate governance. First, John Plender argues in the Financial Times that the Volkswagen emissions scandal was possible "because the ownership structure protected incumbent management," and that it "underlines an important truth with important investment consequences: at the root of most corporate scandals lie governance failures." Maybe, but the direction of the governance failures is inconsistent. The less shareholder-focused German model of corporate capitalism might, you'd think, insulate executives from the short-term pressures of the market. On the other hand, the U.S. system of aligning executives with shareholders through stock options has also been blamed for excessive risk-taking, and even for causing product recalls. Perhaps neither managers nor shareholders fully internalize a company's externalities. In other Volkswagen news: "Is VW’s Fraud the End of Large-Scale Corporate Deception?" And: "Volkswagen May Not Face Environmental Criminal Charges."

Next, Steven Davidoff Solomon writes in DealBook that "a civil war has erupted among shareholders as pension funds and mutual funds fight over what constitutes good governance." The specific fight here was over whether the chairman and chief executive officer roles at Bank of America should be split. Intuitively, having the board run by the CEO, who is also supposed to answer to the board, seems like bad governance, a conflict, a lack of oversight. And Bank of America's decision to combine the roles, reversing a previous shareholder vote, sure looked bad. But empirically:

The studies have yet to show that a separation of the jobs increases a company’s value, and many find the opposite. This may be because simply splitting the positions does not lead to better oversight.

The conflict seems to be between those (Calpers, Calstrs, other public pension funds, proxy advisors) who think of corporate governance as a set of quasi-moral norms that are good in themselves and should be followed by all companies, and those (mutual funds) who think of corporate governance as a set of tools for maximizing shareholder value and who are willing to discard governance rules that do not empirically lead to higher value. "Unlike the pension funds, the mutual funds are becoming more skeptical of the corporate governance revolution," writes Davidoff Solomon. It is tempting to side with the mutual funds: It seems a bit silly to ascribe moral value to unclassified boards or independent directors; if they are not good for shareholders financially, why should the shareholders want them? On the other hand it is hard to resist thinking of governance in moral terms. And, of course, the shareholders aren't the only people affected by corporate decisions, and the shareholders -- the mutual funds anyway -- aren't internalizing externalities. Though I'm not sure that an independent chairman would either.

People are worried about bond market liquidity.

If you've only recently discovered bond-market-liquidity worrying, perhaps after seeing it advertised during Monday Night Football, and you want to get up to speed fast, the International Monetary Fund's Global Financial Stability Report has a chapter on bond market liquidity that is very much worth reading both for newcomers and for long-time fans of the genre. The report distinguishes between the "level of market liquidity -- the ability to rapidly buy or sell a sizable volume of securities at a low cost and with a limited price impact" and the resilience of liquidity: The systemic issue is not so much that liquidity levels might be low now but that liquidity might dry up in a crisis. And it makes some interesting empirical points, including that "pretrade transparency -- measured by the number of quotes -- is positively related to the resilience of market liquidity," that "corporate bond liquidity is more fragile when mutual funds own a larger share," and that "the day after a Treasury auction, aggregate market liquidity drops by nearly 13 percent in high-yield bonds but negligibly for investment-grade bonds," as dealers clear up balance sheet space to buy Treasuries by reducing their high-yield market making. There is also a stress-test model for banks and bond market liquidity:

Policy recommendations include reconsidering the EU ban on naked sovereign credit default swaps (which the IMF concludes reduced European sovereign bond liquidity), more support for electronic trading platforms and bond standardization, careful normalization of U.S. monetary policy, and "measures to reduce liquidity mismatches and the first-mover advantage at mutual funds."

Also, in Money Stuff yesterday, I mentioned my financial thriller idea, in which a character based on Martin Shkreli, the biotech-stock-short-seller-turned-nationally-loathed-biotech-CEO, was actually still shorting biotech stocks even as he was bringing opprobrium and regulation onto the industry. Readers pointed out that that's not as far-fetched as I thought; Shkreli apparently wrote up at least one biotech short case as recently as last month. The stock is down 74 percent since the date of that report, though the drop came before Shkreli's recent antics.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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